The Behavior of Interest Rates

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The Behavior of Interest Rates
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Determining the Quantity Demanded of an Asset

• Wealththe total resources owned by the
  individual, including all assets
• Expected Returnthe return expected over the next
  period on one asset relative to alternative
  assets
• Riskthe degree of uncertainty associated with
  the return on one asset relative to alternative
  assets
• Liquiditythe ease and speed with which an asset
  can be turned into cash relative to alternative
  assets

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Theory of Asset Demand

• Holding all other factors constant
• The quantity demanded of an asset is positively
  related to wealth
• The quantity demanded of an asset is positively
  related to its expected return relative to
  alternative assets
• The quantity demanded of an asset is negatively
  related to the risk of its returns relative to
  alternative assets
• The quantity demanded of an asset is positively
  related to its liquidity relative to alternative
  assets

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Supply and Demand for Bonds

• At lower prices (higher interest rates), ceteris
  paribus, the quantity demanded of bonds is
  higheran inverse relationship
• At lower prices (higher interest rates), ceteris
  paribus, the quantity supplied of bonds is
  lowera positive relationship

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Market Equilibrium

• Occurs when the amount that people are willing to
  buy (demand) equals the amount that people are
  willing to sell (supply) at a given price
• When Bd Bs ? the equilibrium (or market
  clearing) price and interest rate
• When Bd gt Bs ? excess demand ? price will rise
  and interest rate will fall
• When Bd lt Bs ? excess supply ? price will fall
  and interest rate will rise

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Shifts in the Demand for Bonds

• Wealthin an expansion with growing wealth, the
  demand curve for bonds shifts to the right
• Expected Returnshigher expected interest rates
  in the future lower the expected return for
  long-term bonds, shifting the demand curve to the
  left
• Expected Inflationan increase in the expected
  rate of inflations lowers the expected return for
  bonds, causing the demand curve to shift to the
  left
• Riskan increase in the riskiness of bonds causes
  the demand curve to shift to the left
• Liquidityincreased liquidity of bonds results in
  the demand curve shifting right

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Shift in Demand
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Factors that Shift the Bond Demand Curve

• 1. Wealth
• A. Economy grows, wealth ?, Bd ?, Bd shifts out
  to right
• 2. Expected Return
• A. i ? in future, Re for long-term bonds ?, Bd
  shifts out to right
• B. ?e ?, Relative Re ?, Bd shifts out to right
• C. Expected return of other assets ?, Bd ?, Bd
  shifts out to right
• 3. Risk
• A. Risk of bonds ?, Bd ?, Bd shifts out to right
• B. Risk of other assets ?, Bd ?, Bd shifts out to
  right
• 4. Liquidity
• A. Liquidity of Bonds ?, Bd ?, Bd shifts out to
  right
• B. Liquidity of other assets ?, Bd ?, Bd shifts
  out to right

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Shifts in the Supply of Bonds

• Expected profitability of investment
  opportunitiesin an expansion, the supply curve
  shifts to the right
• Expected inflationan increase in expected
  inflation shifts the supply curve for bonds to
  the right
• Government budgetincreased budget deficits shift
  the supply curve to the right

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Shift in Supply
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Loanable Funds Terminology

• 1. Demand for bonds supply of loanable funds
• 2. Supply of bonds demand for loanable funds

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Fisher Effect
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Fisher Effect
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Business Cycle and Interest Rates
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Business Cycle and Interest Rates
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Practice Problems

• What happens to the equilibrium bond price, and
  interest rate in the following scenarios (ceteris
  paribus)?
• Gold prices start to rise dramatically.
• The stock market becomes relatively more liquid.
• The stock market begins to fluctuate wildly.
• Real Estate prices fall sharply.

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Interest Rate Ceilings

• Regulation Q (max interest rate paid on deposits)
• Merchant of Venice (Shakespeare)
• Bassanio, Antonio, Shylock, Portia
• Deuteronomy 2319
• Thou shalt not lend upon interest to thy brother
  interest of money, interest of victuals, interest
  of any thing that is lent upon interest

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The Liquidity Preference Framework
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Liquidity Preference Analysis

• Derivation of Demand Curve
• 1. Keynes assumed money has i 0
• 2. As i ?, relative RETe on money ?
  (equivalently, opportunity cost of money ?) ? Md
  ?
• 3. Demand curve for money has usual downward
  slope
• Derivation of Supply curve
• 1. Assume that central bank controls Ms and it is
  a fixed amount
• 2. Ms curve is vertical line
• Market Equilibrium
• 1. Occurs when Md Ms, at i 15
• 2. If i 25, Ms gt Md (excess supply) Price of
  bonds ?, i ? to i 15
• 3. If i 5, Md gt Ms (excess demand) Price of
  bonds ?, i ??to i 15

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Shifts in the Demand for Money

• Income Effecta higher level of income causes the
  demand for money at each interest rate to
  increase and the demand curve to shift to the
  right
• Price-Level Effecta rise in the price level
  causes the demand for money at each interest rate
  to increase and the demand curve to shift to the
  right

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Shifts in the Supply of Money

• Assume that the supply of money is controlled by
  the central bank
• An increase in the money supply engineered by the
  Federal Reserve will shift the supply curve for
  money to the right

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Everything Else Remaining Equal?

• Liquidity preference framework leads to the
  conclusion that an increase in the money supply
  will lower interest ratesthe liquidity effect.
• Income effect finds interest rates rising because
  increasing the money supply is an expansionary
  influence on the economy.
• Price-Level effect predicts an increase in the
  money supply leads to a rise in interest rates in
  response to the rise in the price level.
• Expected-Inflation effect shows an increase in
  interest rates because an increase in the money
  supply may lead people to expect a higher price
  level in the future.

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Money and Interest Rates

• Effects of money on interest rates
• 1. Liquidity Effect
• Ms ?, Ms shifts right, i ?
• 2. Income Effect
• Ms ?, Income ?, Md ?, Md shifts right, i ?
• 3. Price Level Effect
• Ms ?, Price level ?, Md ?, Md shifts right, i ?
• 4. Expected Inflation Effect
• Ms ?, ?e ?, Bd ?, Bs ?, Fisher effect, i ?
• Effect of higher rate of money growth on interest
  rates is ambiguous
• 1. Because income, price level and expected
  inflation effects work in opposite direction of
  liquidity effect

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Price-Level Effect and Expected-Inflation Effect

• A one time increase in the money supply will
  cause prices to rise to a permanently higher
  level by the end of the year. The interest rate
  will rise via the increased prices.
• Price-level effect remains even after prices have
  stopped rising.
• A rising price level will raise interest rates
  because people will expect inflation to be higher
  over the course of the year. When the price level
  stops rising, expectations of inflation will
  return to zero.
• Expected-inflation effect persists only as long
  as the price level continues to rise.

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Relation of Liquidity PreferenceFramework to
Loanable Funds

• Keyness Major Assumption
• Two Categories of Assets in Wealth
• Money
• Bonds
• 1. Thus Ms Bs Wealth
• 2. Budget Constraint Bd Md Wealth
• 3. Therefore Ms Bs Bd Md
• 4. Subtracting Md and Bs from both sides
• Ms Md Bd Bs
• Money Market Equilibrium
• 5. Occurs when Md Ms
• 6. Then Md Ms 0 which implies that Bd Bs
  0, so that Bd Bs and bond market is also in
  equilibrium

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Relation of Liquidity PreferenceFramework to
Loanable Funds

• 1. Equating supply and demand for bonds as in
  loanable funds framework is equivalent to
  equating supply and demand for money as in
  liquidity preference framework
• 2. Two frameworks are closely linked, but differ
  in practice because liquidity preference assumes
  only two assets, money and bonds, and ignores
  effects on interest rates from changes in
  expected returns on real assets